An Exchange for Physical (EFP) is a particular type of Exchange for Related Position (EFRP) transaction and may be executed in any CME equity index future in accordance with Rule 538 and any associated advisories.1
EFP transactions allow investors to convert between futures and either ETFs or baskets of the underlying index constituent stocks, without exposure to intraday market execution. This not only allows investors to optimize their holdings to meet their leverage, capital, tax and liquidity needs but to also differentiate between the tool they use for trading and how they want to hold their exposure.
In an EFP transaction, two parties exchange equivalent but offsetting positions in an equity index futures contract and an underlying physical equity (either a related ETF or basket of shares). One party is the buyer of futures and the seller of the physical shares, and the other party takes the opposite position. The EFP is a privately-negotiated transaction between the two parties to the trade, where the consummated transaction must be reported to the Exchange.
Because both sides of the trade track the same benchmark, an EFP is market-neutral. As such, the pricing of the EFP is quoted in terms of the basis between the price of the futures contract and the level of the underlying index.
Banks and broker-dealers are active in the EFP market for a variety of reasons. The EFP between futures and ETFs or stock baskets is a key ingredient in the management of inventory street-wide as well as the index arbitrage mechanisms that keep both futures, ETFs and the cash constituents trading in line with their fair value. For example:
An EFRP is a very flexible tool and comports well of OTC swaps and options trading. For example, when trading OTC S&P 500 index options, a CME E-mini S&P 500 index futures or S&P 500 index futures trade can be consummated to exchange the offsetting delta in the transaction, and reported to CME Clearing as an EFRP trade. The E-mini S&P 500 index futures or S&P 500 index futures are considered the listed instrument, while the OTC index option(s) is considered the related position. Please note that only bona fide OTC options trades can be used as the related position. Products listed at another securities or futures exchange are not eligible for inclusion as the related position is an EFRP transaction. Other requirements for EFRP transactions remain applicable.
EFP versus a basket of shares: When executing an EFP versus a basket of shares, the replicating basket is usually a perfect slice of the index. In some cases an imperfect basket may be used (e.g. if the broker is restricted from trading a particular security). The requirement is that the resulting basket of shares is highly correlated with the underlying index and at least a 50% overlap of either the weighting or number of securities.
Tailing futures: When determining the appropriate number of futures contracts to exchange for a given notional of ETFs or underlying cash baskets, brokers may apply a “tail” adjustment whereby the number of futures contracts is reduced slightly. Conversely, the size of the related position, the ETF or basket can also be adjusted if the client wants to trade a set number of futures. This results in slightly different notional values for the two legs of the EFP, but more precisely matches their market exposures (i.e. sensitivity to change). This tail adjustment will be agreed during the private negotiation and is a function of the days to maturity and the level of interest rates. (At the time of writing, due to low rates, this adjustment is very small – on the order of one contract per 1,500.)
NAV pricing: It is market convention to price and trade EFPs with reference to the prior night’s closing share prices (for a cash basket) or NAV (for an ETF). Because the NAV reflects not only the prices of the underlying shares but also the accrued dividends and cash held in the fund, the NAV price may be adjusted by a small amount to reflect any changes that have occurred since the previous day (e.g. underlying stock going ex-dividend). It is also possible to execute the EFP after the market close versus the closing NAV on trade date. In this case, the agreed upon basis (which referenced the prior night’s closing level) may be adjusted slightly (called a “delta adjustment”) to reflect the change in market level since that time.
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